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For services such as construction or car repair, the number of hours needed to complete the project is used. Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too. After reviewing the product cost and consulting with the marketing department, the sales prices were set. The sales price, cost of each product, and resulting gross profit are shown in Figure 6.6. Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be $5,000 per machine hour. By using the predetermined rate product costs and therefore selling prices can be calculated quickly throughout the year without the need to wait for actual overheads to be determined and allocated.

Ralph’s Machine Tools Company assigns manufacturing overhead costs based on direct labor and applies this rate to job orders. A predetermined overhead rate is defined as the ratio of manufacturing overhead costs to the total units of allocation. Enter the total manufacturing overhead cost and the estimated units of the allocation base for the period to determine the overhead rate. One of the advantages of predetermined overhead rate is that businesses can use it to help with closing their books more quickly. This is because using this rate allows them to avoid compiling actual overhead costs as part of their closing process. Nonetheless, it is still essential for businesses to reconcile the difference between the actual overhead and the estimated overhead at the end of their fiscal year.

Predetermined Overhead Rate (Definition, Example, Formula, and Calculation)

The overhead rate for the molding department is computed by taking the estimated manufacturing overhead cost and dividing it by the estimated machine hours. At the start of 2021, Dorothy’s Hat Company estimated that the total manufacturing overhead cost for the year would be $320,000, and the total machine hours would be 50,000 hours. This predetermined overhead rate formula rate is usually calculated at the start of an accounting period by dividing the cost of manufacturing overhead by the activity driver, which is also sometimes referred to as the activity base or allocation base. In production, the predetermined overhead rate is computed to facilitate the determination of the standard cost for a product.

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. Let’s take an example to understand the calculation of Predetermined Overhead Rate in a better manner.